5 Steps to a 5 AP Macroeconomics 2019

Consumption, Saving, Investment, and the Multiplier ❮ 99

The market for loanable funds is shown in Figure 8.7, and the equilibrium interest rate

is found at the intersection of the supply and demand curves. In upcoming chapters, we

investigate the role of this market in the banking system, fiscal and monetary policy, and

economic growth.

•    The    supply  of   loanable   funds   comes   from     saving and  lending.

•    The    demand  for  loanable   funds   comes   from     investment and  borrowing.

•    Equilibrium    is   at  the     real    interest   rate     where  dollars saved   equals  dollars invested.

8.3 The Multiplier Effect

Main Topics: Multiplier Effect and Spending Multiplier, Public and Foreign Sectors, Tax

Multiplier, Balanced-Budget Multiplier

The most simple circular flow consists solely of consumers and firms; in other words,

GDP = C + I. But the public sector (G) and the foreign sector (X – M) are also important

sources of domestic spending and income. Inclusion of these two sectors provides very little

in the way of complications; they introduce the concept of the spending multiplier, the

tax multiplier, and the balanced budget multiplier. This also paves the way for fiscal policy

aimed at macroeconomic stability.

Multiplier Effect and Spending Multiplier

When you buy an ear of corn at the farmers’ market, those dollars serve as income to sev-

eral people. The farmers use those dollars to pay employees, to run their farm equipment,

and to buy their own food. Farm employees use those wages to buy bacon, pay the rent,

and many other goods and services. The circular flow explains how the injection of a few

dollars of spending creates many more dollars of spending. Follow the dollars for a few

rounds to see how it works. With the marginal propensity to consume (MPC) of .80, if

households receive a $1 of new income they spend $0.80 and save $0.20.

Figure 8.7

Real Interest Rate

Loanable Funds ($)

S

D

$F

r %

TIP

KEY IDEA

“Make the

con nections

between con-

cepts learned in a

previous chapter

to what you are

learning now,

because every-

thing is cumula-

tive.” ––Caroline,

AP Student